Editor's Note

This year’s Tax Guide was written in what could turn out to be the eye of a tax legislation storm.

As we went to press, the Joint Select Committee on Deficit Reduction announced its failure to reach a bipartisan agreement. The lack of a compromise has both tax and investment implications.

The most obvious implication relates to our country’s deficit. Though current legislation calls for $1.2 trillion in cuts to be triggered in 2013, some members of Congress are already looking for ways to stop them. More importantly, we remain without a long-term plan for bringing down our deficit. As you know, this has the potential to drive up future interest rates.

Another implication is continuing uncertainty about taxes. This year’s payroll tax cut expires in 2011 and, although President Obama has asked for its extension, Congress has yet to authorize legislation to do so. Exemptions for the alternative minimum tax (AMT) will shrink considerably in 2012 if Congress does not pass yet another AMT fix. The ability to deduct state sales taxes also ends on December 31, 2011.

Looking further out, the Bush-era tax cuts expire on December 31, 2012. The current estate tax, which has a $5 million portable exclusion in 2011, will also expire on that day. New Year’s Day 2013 will bring higher tax rates and the disappearance of many tax credits and deductions if Congress does not reach a compromise beforehand.

The expiration of these cuts impacts not only individual taxpayers, but also businesses.

The uncertainty makes it difficult to plan. From the standpoint of investors, the lack of tax clarity creates more headwinds with the potential to slow the pace of economic and earnings growth. (Executives are more reluctant to spend if their future cash flows are difficult to forecast.)

Compounding matters is the forthcoming presidential election. A divided Congress combined with a hard-fought election and a large quantity of special interest advertising do not provide conditions conducive to revamping the tax code and creating a pragmatic solution for reducing the country’s debt. I’m loath to make predictions right now about what 2013 taxes will be.

To help cope with the uncertainty, use the next 12 months to seek out ways to make your portfolio more tax-efficient. This means thinking about which accounts you put certain assets into. Tax-efficient investments, such as municipal bonds, should be held in a taxable account. The least tax-efficient investments, such as mutual funds with high turnover, belong in a tax-deferred account.

The tax guide is not the only commentary in this month’s issue. There are three other feature articles that I think you will enjoy.

The first is John Bajkowski’s First Cut. John applied Joel Greenblatt’s Magic Formula to identify the 30 stocks with the highest combined rank based on Greenblatt’s value and return on enterprise measures. These stocks are listed here.

The second explains how to analyze young growth companies. These are companies with rapidly growing revenues and bright futures, but little to no current profits. Thus, traditional valuation measures, such as price-earnings and price-to-book ratios, do not work well. Rather, assigning a valuation requires a combination of making assumptions and looking at more established companies. Aswath Damodaran, a professor of finance at New York University, shows you how to do this here.

The third discusses a strategy for dampening the volatility of your portfolio. Stuart Ritter of T. Rowe Price says a portfolio composed of 60% stocks and 40% bonds has 40% less volatility than a 100% stock portfolio. Long-term annualized returns are lower, 8.52% versus 9.87%, but the trade-off might be worth it from an emotional standpoint. You can see Ritter’s study here.

On behalf of everyone at AAII, I wish you happy holidays, and a healthy and prosperous new year,
Charles Rotblut, CFA
Editor, AAII Journaltwitter.com/charlesrotblut